The best way to take income from your portfolio

An approach that combines taking natural income and creating your own is the best course of action. Recent changes to wrappers and tax rules mean it is also a good idea to check if you have the balance right, and to ask yourself whether you are taking income in the most sustainable and tax-efficient manner.

A total return approach to investing combines dividend-producing shares and funds with selling down units to provide extra cash. Even if you do this already, you should think about what proportion of income you are taking from each chunk.

"Many moons ago, if you were generating income with a technically fairly medium-to-low risk outlook, you were invested in fixed income and even the safest AAA-rated government-backed gilts were paying a 3-5 per cent yield," says Peter Lowman, chief investment officer at Investment Quorum. "Now the pressure on getting income is extreme due to falling bond yields. Investors are rushing into equity income, but that is becoming a crowded trade. Even among FTSE 100 stocks, which have been a classic example of income and growth, and a source of good yields, many companies are cutting dividends, particularly in oil and gas, mining and banking. The old level of yield is just not achievable any more."

The natural yields that portfolios can be expected to generate has reduced dramatically in recent years and it is no longer easy to get a high income just with income-generating funds and shares. But selling units means you are not forced to focus on particular types of investment and only invest in distributing share classes. However, there are risks when creating your own dividends from capital growth.

Taking income from profits depends on that asset continuing to rise in value. If markets turn and your assets fall, you will no longer be able to draw the same level of income from your assets. Even when markets are rising, taking too much income could run your portfolio dry and cause you pain further down the line.

Unlike dividends, which are relatively predictable and consistent, it is impossible to know which way markets will move and how your portfolio is likely to perform in any given year. That makes it very hard to take a consistent and sustainable income from capital growth alone.

And selling units at the wrong time could eat away at your pot. "The difficulty with capital withdrawals is timing," says Leon Buckley, chartered financial planner at Tilney Bestinvest. "If you repeatedly sell units in a falling market, you are going to have to sell more and more units to realise the same amount over the long term, which can have a terrible impact on your portfolio."

Mr Lowman adds: "Taking a growth and income approach is more flexible and a smoother ride. If you're betting the bank on growth and it doesn't come through then you will start eating into your capital. But on the other hand if you're betting just on income and don't get those products right, for example you buy companies paying unsustainable dividends, that's bad too."

Another benefit of a total return approach, which mixes the two methods, is that it enables you to be far more flexible about the assets you invest in. Lee Robertson, chief executive officer at Investment Quorum, says he is moving away from bonds towards global equity funds in his clients' portfolios to generate both income and growth.

A total return asset allocation model today might be a balance of global growth equity funds, bonds and UK-focused investments, and could look fairly different to the bond-centric income portfolio you would have held 10 years ago. "Diversification is really important in the current environment - you don't want to be too focused on a handful of different asset classes," says Martin Bamford, managing director at Informed Choice. "Typically income investors have been invested in corporate bonds and UK equity income, but with a total return approach the whole world opens up to you and you can really spread your investment across a lot of different things, which reduces your risk level too."

Mr Lowman currently prefers a portfolio of about three-quarters equities and one-quarter bonds. But Colin Low, managing director of Kingsfleet Wealth, prefers to hold fewer equities, particularly in lower-risk portfolios, and also holds absolute-return funds to try to include assets that will not behave in the same way at times of market stress.

Mr Bamford recommends a traditional 60:40 equity:bond split for a medium-risk portfolio.

Tax benefits

A total return approach also enables you to maximise your tax-free allowances. If you invest within a tax-efficient wrapper such as an individual savings account (Isa) or pension your gains will be tax-free. However, if you are saving outside of these you will incur capital gains and dividend taxes, so should be making the most of exemptions and lower rates where you can.

For the 2016-17 tax year you have a generous capital gains exemption of £11,100. This is the amount you can gain on your investments, not the amount you can withdraw before incurring tax, meaning you should be able to take a far higher sum than that from your investments before hitting that amount (see box). The capital gains tax (CGT) rate was slashed in the March 2016 Budget so that basic-rate taxpayers pay 10 per cent on gains, and 18 per cent on residential property gains, while higher-rate taxpayers pay 20 per cent or 28 per cent for residential property.

By contrast, basic-rate income tax is 20 per cent, higher-rate is 40 per cent and additional-rate is 45 per cent. You can also offset losses against capital gains, further reducing your CGT liability.

Since April, meanwhile, investors have been able to receive £5,000 of dividends tax-free. Under the old tax credit system, basic-rate taxpayers earned dividend income tax-free, but higher- and additional-rate taxpayers paid 25 per cent and 30.6 per cent. For dividends above the first £5,000 earned, basic-rate taxpayers pay 7.5 per cent tax, higher-rate taxpayers pay 32.5 per cent and additional-rate taxpayers pay 38.1 per cent.

By taking income from both dividends and selling units, you can make the most of both allowances and earn a significant amount of investment income before paying any tax.

"Now is the time to mix (capital and growth) because you've got two large allowances to use," says Mr Low. "The government is letting you make £16,000 a year on unwrapped funds without paying any tax, which many people often overlook."

What level of income could you take?

The hard truth is that with income and growth both looking fairly anaemic, you might well have to come to terms with a lower income from your investments than you would like. Most commentators suggest a figure of around 3 per cent as a sustainable income figure, depending on the size of your pot and risk appetite.

"The very broad-brush approach we take is that a maximum 4 per cent has historically been shown to be the highest level of drawdown during decumulation [when you have stopped paying into your pot] which savers can take without fear of running out of money during their lifetime," says Patrick Murphy, managing partner at Zen Wealth.

"Our moderate risk portfolio has an income expectation of 3.1 per cent and growth of 2.7 per cent, which makes a total of 5.8 per cent," says Mr Bamford.

But he warns against taking that full amount and says a safe withdrawal rate for UK investors should be around 3 per cent.

Mr Lowman says you could feasibly hope for an 8 per cent total return a year from a portfolio, with 3 per cent coming from income and 6 per cent from growth, and suggests you could take a 5 per cent dividend on that basis.

When it comes to actually taking the income, you need to plan a strategy that prevents you from selling at the wrong times and running down your pot, but which also gives you a good income flow. Mr Bamford, Mr Murphy and Mr Buckley all recommend one strategy for taking consistent income and managing your income throughout market cycles.

This strategy involves taking a consistent monthly income from dividend yield and a variable annual income from capital gains. So you take the natural yield from your portfolio as monthly or quarterly income, and the profits on your most successful funds and investments at the end of the year, depending on how your portfolio has performed. As part of that, you should start out with a cash reserve which you can use to top up income over the course of the year, and then replenish it at the end of the year from capital growth.

"We advise clients to hold a multiple of the year's income they want in cash at the outset, and then top up at the right times," says Mr Buckley. "So you take profits annually when things are going well, but if markets are down when you come to take profits again in a year's time, you make a call on whether to surrender units but still have a cash buffer to protect you from becoming a forced seller."

Mr Low refers to this as having a "slush fund account" which you can top up with the natural yield on an ongoing basis, and capital gains on a less frequent basis.

"The money you hold in cash is not generating great returns, but that is the price you might have to pay for the sustainability of income," says Mr Murphy. "You don't want to be selling equities if markets turn against you."